Building a diversified ETF portfolio in Canada is not simply a matter of holding several ticker symbols. Useful diversification means spreading money across investments that do not all have the same risks, return drivers or response to economic conditions.
Exchange-traded funds can make that process more accessible because one ETF may hold many shares or bonds. But ETFs are not automatically diversified in the same way. A fund can be heavily concentrated in one industry, country, currency or small group of issuers. Before building a portfolio, look at what each ETF actually owns, rather than just counting how many ETFs appear in the account.
This article offers a general decision framework for organizing and reviewing a portfolio. It is educational information, not personalized investment advice or a recommendation to buy or sell any security.
Start with the job the money needs to do
The first choice is not an ETF. It is the purpose of the money. Funds intended for a near-term expense face different constraints from money set aside for a long-term goal. When a withdrawal date is close, a market decline shortly beforehand can matter more than it would for money that may remain invested for many years.
A practical starting note can include:
- the goal for the portfolio;
- when the money may be needed;
- how much fluctuation you could tolerate without abandoning the plan during a downturn;
- cash needed for spending and emergencies; and
- the accounts involved, such as a TFSA, RRSP, FHSA or non-registered account.
Registered accounts are tax containers, not investments themselves. They can hold different qualified investments, including many ETFs. Contribution, withdrawal and tax rules vary by account and by personal circumstances. Confirm the applicable rules with the Canada Revenue Agency or a qualified professional before making tax-related decisions.
Understand the three layers of diversification
A broadly diversified portfolio is usually reviewed at three levels: across asset classes, within each asset class and across regions.
1. Spread exposure across asset classes
Equities, fixed income and cash do not carry the same risks. Equities provide exposure to companies’ growth and profits, but their market value can move sharply. Bonds and other fixed-income securities can also decline in value, particularly when interest rates change or credit conditions weaken, although they may behave differently from equities. Cash and cash equivalents are generally less volatile, but inflation can reduce their purchasing power.
The percentage assigned to each category is called asset allocation. It often has a greater influence on the portfolio’s overall pattern of volatility than a choice between two similar ETFs. A portfolio with more equity exposure may experience larger swings. More fixed income or cash can moderate some swings, while also limiting long-term growth potential. No asset mix removes every possibility of loss.
2. Diversify within equities and fixed income
Owning a Canadian equity ETF is not the same as owning a global equity portfolio. Canada’s market has meaningful weight in certain areas, including financial services, energy and materials. Investors assessing diversification may therefore examine exposure to the United States, developed international markets and, depending on the chosen mandate, emerging markets.
The same principle applies to fixed income. A bond ETF may hold government bonds, corporate bonds, short- or long-term bonds, Canadian or foreign issuers, and securities with different credit quality. Two ETFs labelled “bond” can therefore respond quite differently to rising rates or stress in credit markets.
3. Look for hidden overlap
Adding more ETFs does not necessarily add more diversification. For example, a Canadian broad-market ETF, a Canadian bank ETF and a Canadian dividend ETF may own many of the same companies. The result can be a portfolio that looks varied on a screen but is more concentrated than intended.
To identify overlap, compare the top holdings, sector weights, country exposure and indexes tracked. The Canadian Securities Administrators’ ETF Facts document is a useful starting point. It summarizes the fund’s investments, risk rating, management expense ratio, trading information and other key details.
Two straightforward portfolio structures
There are many ways to organize ETF holdings. The following are common educational models, not universal prescriptions.
Option A: a single asset-allocation ETF
An asset-allocation ETF generally combines several underlying ETFs and targets a stated mix of equities and fixed income. Its main advantage is simplicity: one holding can provide exposure to multiple asset classes and markets, and the manager typically rebalances within the fund.
The trade-off is less control. The investor accepts the fund’s target allocation, underlying holdings and rebalancing method. It is still important to assess whether its equity weight, bond exposure, international allocation, fees and risks fit the portfolio’s intended role.
Option B: a small group of core ETFs
Another approach is to hold separate ETFs for Canadian equities, U.S. equities, international equities and bonds, for example. This can give an investor more control over target weights and make it possible to change one component without changing the others.
However, it also requires more maintenance. The portfolio owner needs to monitor weights, overlap, trading costs, distributions and the gap between the intended allocation and the actual one. A more detailed structure is not automatically better if it becomes difficult to understand or maintain.
Assess costs beyond the MER
The management expense ratio, or MER, combines management fees and operating expenses. It is expressed as an annual percentage and reduces the fund’s return rather than usually appearing as a separate bill. Comparing MERs is useful, but it is only part of the cost picture.
A fuller review also considers:
- brokerage commissions, where applicable;
- the bid-ask spread, which is the gap between the price available to sell and the price available to buy;
- currency conversion costs, if relevant;
- account maintenance or inactivity charges; and
- trading costs inside the fund, which are not all captured by the MER.
Low cost does not make an unsuitable mandate suitable. Conversely, an overly complicated portfolio can create more transactions and expenses without meaningfully improving diversification. The goal is to understand the total cost and the specific job of every holding.
Set a rebalancing process before markets test it
Over time, different returns cause portfolio weights to drift. If equities rise sharply, they may become a larger portion of the portfolio than originally planned; after a decline, they may become smaller. Rebalancing means moving the portfolio back toward its intended allocation under a rule established in advance.
A rule could be calendar-based, such as a scheduled review, or based on a material departure from target weights. In a non-registered account, selling to rebalance can create tax consequences. Where it fits an investor’s plan, new contributions or cash distributions may sometimes be used to address differences in weights without immediately selling an existing holding.
The important point is to avoid turning rebalancing into a response to headlines or recent performance. Past performance, including over several years, does not guarantee future results.
Risks diversification cannot remove
Diversification can reduce company-, sector- or country-specific risk, but it cannot eliminate market risk. During a broad market crisis, many assets may decline at once and bid-ask spreads may widen. ETFs may also involve interest-rate, credit, currency, liquidity and index-tracking risks and, depending on the fund, derivative or leverage risks.
An ETF with a low risk rating can still lose money. Distributions are not guaranteed either, and they should not be confused with total return. A distribution may include dividends, interest, capital gains or, in some circumstances, return of capital.
Reviewing the ETF Facts document helps, but it does not replace understanding the fund’s prospectus and strategy. The document shows past results and stated risks; it cannot predict how a fund or market will perform next.
A checklist before adding an ETF
- What is its role? Is it meant to provide equities, bonds, cash-like exposure, a regional allocation or a specialized mandate?
- What does it own? Review the index, top holdings, sectors and countries.
- Does it add a new exposure? Or does it duplicate a holding already in the portfolio?
- What are the risks? Read the risk rating, ETF Facts and prospectus.
- What are the all-in costs? Consider MER, spreads, commissions, account fees and currency conversion.
- How will it be rebalanced? Decide on a method before a large market move makes the decision emotional.
A diversified ETF portfolio does not need to be complicated. It needs to be consistent with a goal, time horizon, ability to withstand fluctuations and monitoring process that you understand. If setting those elements is difficult, a registered adviser can help assess the suitability of an approach in the context of your own circumstances.
Sources reviewed
These sources support verification and further reading.
- Diversification : pourquoi diversifier votre portefeuille? — Organisme canadien de réglementation des investissements (OCRI / CIRO)
- ETF Facts — Autorités canadiennes en valeurs mobilières (ACVM / CSA)
- Fees and Costs — Organisme canadien de réglementation des investissements (OCRI / CIRO)
- What diversification means for your investments — GetSmarterAboutMoney.ca, Commission des valeurs mobilières de l’Ontario
- Saving for the future — Agence du revenu du Canada